Public Finances in EMU – 2009

The report reviews how Member States are tackling the challenges from the financial and economic crisis. It assesses the prospects for public finances and policy needs ahead based on past experiences with financial crises. The analysis reveals that direct and indirect fiscal costs of the financial crisis will be massive. It finds that quick, resolute and comprehensive policy responses in the financial sector, together with an exit strategy of timely unwinding government interventions can contain the costs. In addition to the direct fiscal costs of interventions in the financial sector, large fiscal deficits and low economic growth rates lead to sharp increases in government debt ratios.

When analysing a subset of 49 crisis episodes from the 122 systemic financial crises that occurred since 1970 around the world, Commission staff find that net direct fiscal outlays to rehabilitate the banking system averaged 13% of GDP but were much higher in some cases, notably emerging market economies.

Experience shows that some factors have contributed to containing the level of direct fiscal costs. Lower direct fiscal costs and higher recovery rates were achieved notably, taking into account the severity of the crisis, when the banking crisis resolution strategy was
implemented swiftly;
transparent and received broad political support;
backed by strong public institutions and legal frameworks;
consistent in terms of fair and uniform treatment of market participants; and
part of a clear exit strategy, including restructuring of the banking sector.

Increases in public debt-to-GDP ratios, the most comprehensive measure to capture fiscal implications from financial crises, went far beyond the direct costs attributable to tackling the financial sector problems and amounted to, on average, 20 percentage points during the crisis, which lasted on average 4½ years.

The most recent Commission services forecasts project the public debt-to-GDP ratio in the EU, which just surpassed the 60% mark in 2008, to jump by 21 percentage points from its low in 2007 to 79.4% of GDP from in 2010. The high deficit levels, which are to a significant extent structural considering the nature of the economic and financial shocks, suggest further rising debt ratios in the years beyond 2010. Experience suggests that any lagging behind of bank resolution policies risks adding to the fiscal bill. Efforts to restore the health of the financial sector, even when it implies high upfront fiscal outlays, are a condition to ensure the full effectiveness of fiscal measures in support of an economic recovery.

The budgetary developments differ significantly across Member States. Credit markets and asset prices have played a key role in this context. Countries that experienced the strongest credit and property booms also had growing current account deficits and the most buoyant tax revenues and public expenditure growth during the boom. They are now experiencing the largest tax revenue shortfalls and deficit and debt increases during the downturn. In a number of these countries with large macroeconomic imbalances, fiscal space available to run counter-cyclical fiscal policy without incurring sharp increases in sovereign and economy-wide risk premia had been curtailed from the start of the crisis. Better tailored fiscal policy should aim at building-up surpluses to tame down buoyant demand during booms and allowing running counter-cyclical fiscal policies during busts.